Solvency II and UK internal capital assessments Casualty Loss Reserving Seminar 2008 Gavin Hill Actuarial & Insurance Solutions Deloitte & Touche LLP 19 September 2008

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Agenda 

Brief overview – Solvency II – ICAS



Internal Models – Why? – Models? – What is a real internal model? – What is a good internal model?



What have we learnt in the UK?

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Brief overview

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Brief overview

ICAS – Individual Capital Adequacy Standards: an FSA RBC regime – Pre-empt introduction of European framework – Tried to anticipate the design & nature of Solvency II – 2005 onwards

Solvency II – Proposed unified, prudential reserving & regulatory framework for European Union insurers & reinsurers – Long-term & Short-term – Policyholder protection, fair & stable markets – 2012?

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What is Solvency II? Future European solvency regime for the insurance industry based on the following principles: – Basel II three-pillar structure adapted for the insurance sector – move away from one approach fits all to an approach geared to the risks which companies are exposed to; it encourages companies to measure and manage risk – takes into account the risks associated with the company’s organisation and management approach – providing sufficient capital in order to reduce the risk of ruin to an acceptably low level and hence increase the level of protection to policyholders – make allowance for subsequent adaptation to international prudential and accounting developments and be designed to avoid a proliferation of reporting systems and regulatory arbitrage.

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Solvency II – the three pillar regime • Three pillar structure from Basel II is to be adopted for the insurance industry. • The new system is intended to offer insurance companies incentives to measure and better manage their risk situation. • New solvency system will include both quantitative and qualitative aspects of risk. SOLVENCY II Market Risk

GI Underwriting Risk

Pillar 1

Pillar 2

Pillar 3

• Asset/Liability valuation rules (MVs)

• Supervisory Review Process (SRP)

• Disclosure requirements (transparency)

• COC approach (Liabilities)

3 Risk Self Assessment • Own (ORSA)

• Robust Risk MI policy (internal vs.. external)

• MCR and SCR

• Risk management 3 framework

• Stakeholder communication (market standing)

• Standard vs. internal model

• Own funds

• Reputation risk

• Correlation/Diversification

3 add-on • Capital

• Competitive factor

• Release of reserve margins Default Risk

Life underwriting Risk

• Group Supervision Operational Risk

3 Quantitative

Qualitative

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Disclosure

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Pillar 1 - Comparison of Solvency I and Solvency II Solvency I

Solvency II

Free Surplus

Solvency 1

Solvency capital requirement (SCR)

Book value of the assets

Minimum capital requirement (MCR)

Technical provisions

Assets covering technical provisions, the MCR and the SCR

Risk margin (MVM) ... for non-hedgebale risk components Best estimate

Technical provisions Market-consistent valuation for hedgeable risk components

Solvency II valuation rules

• Both assets and liabilities are to be fair-valued (market value of assets and liabilities). • An explicit risk margin (market value margin) is to be added to the fair value of the liabilities to give the technical provisions. • This risk margin should be calculated using a cost of capital method

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Pillar 1 – Technical Provisions

Probability density

Market Value Margin (MVM): By definition, risk margin in addition to the best estimate liability (i.e. the expected present value of best estimate future cash flows) required by the market Additional risk margin for prudence: This quantity may be positive, negative, or zero (shown here as positive). • No reason to believe that the “confidence interval” value is market consistent • Underlying volatility obscured • Risk-taking obscured

MVM

e.g. 75th percentile

  Best Estimate

Liability Value Liability value at specified confidence interval

Market price / Marketconsistent value

Solvency II valuation rules

• An explicit MVM is not applicable for hedgeable liabilities, which are always valued at market price. • The MVM is already included in the market price and no further adjustment is necessary. • An explicit MVM is only applicable for non-hedgeable non-financial risks and (possibly) non-hedgeable financial risks 8

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ICAS vs Solvency II: Structure Pillar 1

Pillar 2 Free Surplus

Free Surplus

ICAS

Solvency II

ICA

ICG MCR

MCR

Assets Technical Reserves

Technical Reserves

Free Surplus

Free Surplus

SCR

Pillar 3 Regulatory Returns

Admissible Assets

Disclosure Requirements

Add-ons MCR

MV of Assets

SCR MCR

Risk Margin

Risk Margin

Realistic Liabilities Firm analysis

MV of Assets

Realistic Liabilities Risk Governance Analysis 9

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Solvency II vs.. ICA : Pillar 1 – Risk Quantification Differences: •

Solvency II requires market consistent valuation of liabilities using cost of capital method rather percentile method

•

Solvency II will give options to insurers to use both a standard formula (SCR formula) or internal model or partial model. ICA is an internal risk based capital model and there is no standard or set formula but the FSA do specify broad rules and guidelines.

•

In Solvency II standard formula is “prescriptive” in the sense that most of the fundamental risk parameters (e.g. volatility, correlation matrices, yield, credit defaults) are already specified by the regulator and calibrated to industry experience although some credit is given to own experience via credibility factors.

•

The Solvency II standard formula is expected to provide an incentive to use an internal model – ‘average’ QIS 3 result was 150% of internal model

•

Asset localisation rules apply under Solvency II: assets in relation to EU insurance technical reserves must be held in the EU

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The Solvency Capital Requirement (SCR) – proposed structure SCR

BSCR SCRnl

SCRmkt

SCRop

SCRhealth

SCRdef

SCRlife

NLpr

Mktfx

Healthexp

NLcat

Mktprop

Healthcl

Lifelapse

Lifelong

Mktint

Healthac

Lifeexp

Lifecat

Mkteq

Lifedis

Liferev

Mktsp

= Adjustment for the risk-mitigating effect of future profit sharing

Mktconc

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Lifemort

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Putting things into perspective Solvency II – impacts many areas

People

Accounts

Audit

Tax

Communication

Systems

Risk Governance

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Internal Models

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Where does this leave us? •

For many companies we expect there to be a material financial incentive to have an approved Internal Model

•

Technical flaws in the standard model suggest that even a partial model could result in significant financial gains

•

Timescales, the approval process and the need for evidencing the ‘use test’ mean that established Internal Models need to be in place at the earliest opportunity

•

The ‘hurdle’ to achieve Internal Model approval is expected to be significant

•

So what is an Internal Model?

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Internal models

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Internal models What is a real internal model?

“…All capital models give the wrong answer. Better to have a simple model that you understand – and gives the wrong answer – than a complicated model you do not understand – and still gives the wrong answer…”

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Internal models Actually: It’s not just about the Model

Parameterisation

Integration

Audit

Calibration

Development

Validation

Maintenance

Governance

Design

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Scenarios

Documentation

Build

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Internal models What is a real internal model?

• The IAIS definition of an internal model is more than a mathematical model: Internal model refers to “..a risk management system developed by an insurer to analyse the overall risk position, to quantify risks and to determine the economic capital required to meet those risks” “..where an internal model is used by an insurer for the purposes of determining economic capital, it should fully integrate the processes of risk and capital management in the context of the enterprise risk management (ERM) framework established by the insurer and its ORSA undertaken as part of that framework.”

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Internal models What is a real internal model?

If a firm has an internal model, it will form a key part of the ORSA. This will require appropriate investment in: • Developing a risk management framework, including a risk appetite • Developing a capital model linked to the risk management framework • Implementing the output from the internal model into decision making • Embedding a culture in the firm that understands the risk framework and uses it in day-to-day decision making

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Internal models What is a real internal model? Risk appetite

Risks assumed

Insurance risk policy

Market risk policy

Insurance risk

Risk register

Capital model

Market risk

Credit risk policy

Management reporting

Credit risk

Reinsurance purchasing

Strategy 19

Pricing

FCR/ORSA

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Internal models What is a real internal model? Aspects of an internal model • Management Information

• Strategy/ business planning

• Reserving

• Documentation

• Pricing

• Cashflow modelling

• Reinsurance

• Management actions

• Credit / counterparty risk

• Reporting

• Market risk

• Economic scenario generator (ESG)

• Operational risk

• Systems and controls

• Liquidity risk

• Solvency requirements

• Underwriting risk

• ERM

• Governance

• Senior management performance/ reward

• ALM • Stress and scenario testing

• Capital allocation 20

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Internal models What is in a good Internal Model? Insurance, Market, Credit and Operational risks will all be included Risk Coverage

Will project annual cashflows over multiple years, enabling construction of all relevant accounting templates (GAAP, Economic, Solvency II, IFRS, SST) Integrated – risks not in silos and able to interact Automated – parameters and data captured as part of routine business, extending scope of current process if necessary, eg reserving process

Data and parameters

Include full Cat model output eg RMS, AIR etc Clear ownership – parameters reviewed and signed off by owners, eg claims parameters signed off by underwriters Model looks like a stochastic insurance company business plan

Method, design, detail

Intuitive and easy to understand, using appropriate software Owned by the business (risk function), not an individual Generates and retains data that is relevant to how the business is run

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Internal models What are regulators looking for? Well documented – ‘dead team test’, 500% ICA workload Design, build and method

Familiar methods – no surprises please Evidence of testing, review and independent sign-off Control framework – changes designed and agreed in advance, evidence

Statistically relevant and justified, alternatives considered Data and parameters

Sensitivity tested, owned, regularly reviewed, signed-off, validated and calibrated Well understood and communicated Understood by senior management

Evidence of use

Capital allocation, risk based performance monitoring, aligned to remuneration Impact of strategic options evaluated and considered before decisions are made 22

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Internal models Integrated capital modelling Wide range in where companies have got to – typically a two to five year process Evolution

Requires mandate from the Board Seen as an evolving process

ROC targets, across cycle, by line of business Results and trends reported to the Board – by line of business Claims parameters reviewed, signed-off or modified and owned by underwriters Examples

Reserving process expanded to include estimate of full range of possible outcomes, including estimate of rate of emergence of uncertainty Remuneration aligned to ROC targets Exposures tracked and managed – limits and model aligned Strategic opportunities evaluated and compared

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What have we learnt in the UK?

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What have we learnt in the UK? Objectives and focus • Which risks really matter in this model? –

The 1 in 200 risk or the 1 in 4

• Pragmatism –

Just because we can model it…

–

Technically we should…

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There is never enough data

–

Margins on margins…

–

Integrated models, individual risk models and stress testing

• Understanding the true purpose of what we are doing?

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What have we learnt in the UK? Transparency & simplicity • Important you can explain what your model does? –

With a level of detail appropriate for the audience

–

In clear language

• The dangers of a ‘black box’ owned by the actuaries –

Understanding

–

Resources

–

Key person dependencies

–

Design

• Lots of models out there –

Key model differences

–

Our recommended approach

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What have we learnt in the UK? Communication • In building the model, and once it’s built, communication is key –

Target the audience (external or internal)

–

Often overlooked

–

Plain language

• External –

Regulator

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Ratings agencies

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Auditors?

• Internal –

The board

–

Underwriters

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What have we learnt in the UK? Efficiency & links • Re-using (embedding) existing knowledge and data –

Reserving

–

Pricing / underwriting

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Reinsurance purchase

–

Catastrophe modelling

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Investments and credit risk

• Consistency –

Methods

–

Prudence

–

Purpose

–

Embedded-ness

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What have we learnt in the UK? Flexibility • Rapidly moving goalposts require that models can be easily adapted to satisfy evolving requirements –

Regulatory driven

–

Internally driven

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Linked to embedded-ness

• Models must have the ability to answer more than one question –

1 year time horizons, business planning horizon, to ultimate

–

Regulatory risk measure, internal risk measure, other

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Strategic

• Models must be easy to use, and (relatively) quick to run

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What have we learnt in the UK? Ownership • Important the model is owned by the company… –

Risk management function

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Risk committee

• … and not just by individuals –

Actuaries

–

Underwriters

• Model control –

Can the model be audited

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Can the model be changed

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Can you tell if the model has been changed

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Independent review of model design, build, parameterisation, results

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Validation and calibration

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Questions? Gavin Hill Actuarial & Insurance Solutions Deloitte & Touche LLP +44 (0)207 303 6154 +44 (0)7770 831 505 [email protected]

This presentation has been prepared solely to assist the audience to understand Solvency II. It is necessarily a summary and does not contain all matters relevant to a proper understanding of Solvency II. It is not intended to form the basis of any decisions and you should not rely on its content for any purposes whatsoever. The views contained in the presentation are those of the individual presenter and should not be taken to represent the views of Deloitte. In this presentation Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, its member firms, and their respective subsidiaries and affiliates. As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each other’s acts or omissions. Each of the member firms is a separate and independent legal entity operating under the names “Deloitte”, “Deloitte & Touche”, “Deloitte Touche Tohmatsu”, or other related names. Services are provided by the member firms or their subsidiaries or affiliates and not by the Deloitte Touche Tohmatsu Verein. In the UK, Deloitte & Touche LLP is the member firm of Deloitte Touche Tohmatsu and services are provided by Deloitte & Touche LLP and its subsidiaries. Deloitte & Touche LLP is authorised and regulated by the Financial Services Authority.

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